How Is Passive Income Taxed?

What Is Passive Income?

Passive income is a way to earn money on autopilot. Most opportunities require an upfront investment of time, money or both.

According to IRS Publication 925, there are two forms of passive activities:

• Business or trade activities that you don't materially participate in.
• Rental activities (even if you materially participate)—except for activities done to fulfill your duties as a real estate professional.

By the IRS definition, examples of passive activity include renting out a residential property or owning a silent interest in a limited partnership or S corporation. If you worked 500 hours or more in a business, or if you were essentially the only one operating the business, your business interest isn't passive by IRS standards.

Some people use investments to create passive income streams. Investments aren't taxed as passive income; they're typically taxed as dividends, long- and short-term capital gains or interest.

Learn more: What Qualifies as Taxable Income?

Is Passive Income Taxable?

Passive income is taxable, but it may be taxed differently depending on the type of passive income you have. Passive income as defined by the IRS is typically taxed at the same marginal tax rates (based on tax brackets) as regular earned income. Other types of passive income may be taxed differently. Here's a quick look at how some types of passive income are taxed versus active earnings and investment income:

• Real estate rentals: Taxes on passive income from real estate rental are reported on Schedule E on your Form 1040 tax return.
• S corps and limited partnerships: Passive income from silent investments in an S corporation or limited partnership is also reported on Schedule E.
• Wages: Earned income from employment is subject to marginal tax rates plus payroll taxes for Medicare and Social Security.
• Self-employment income: Net proceeds from self-employment are taxed at marginal tax rates plus self-employment tax, after allowing deductions for regular business expenses.
• Long-term capital gains: Long-term capital gains (on assets held for more than a year before selling) are taxed at 0%, 15% or 20%, depending on your taxable income.
• Short-term capital gains: Gains on assets held for a year or less before selling are taxed at marginal tax rates.
• Dividends: Dividends may be taxed the same as either ordinary income or long-term capital gains.
• Interest: Bank interest is taxed the same as regular earnings.

Active vs. Passive Income Tax

In many cases, active and passive income are taxed the same. However, passive income reported on Schedule E is subject to a passive loss limitation. You can't use a passive loss to offset non-passive income, with an exception for rental real estate losses: You can use up to $25,000 in losses from real estate rental to offset other income if your adjusted gross income is $100,000 or less and you meet other IRS qualifications. See instructions for Form 8582 Passive Activity Loss Limitations for more information.

Be aware: If you use investments to generate passive income and you make more than $200,000 in a year ($250,000 for joint filers), you may have to pay a net investment income tax (NIIT) of 3.8% on either your investment income or the amount of your adjusted gross income (AGI) that exceeds the NIIT threshold, whichever is less.

Learn more: How Are Stocks Taxed?

How to Earn Passive Income

Developing passive income streams can be a great way to boost your income and save toward goals. Although some passive income methods require a substantial upfront investment (perhaps in exchange for a higher payout), others don't cost much and are within reach of regular working people.

Here are some possible ways to earn passive income.

• Rental real estate: Whether you purchase a rental property or rent out a spare room in your home, making money from real estate rental is a common way to generate passive income. For short-term rentals, you can create a listing on Airbnb or a similar service to market your property and streamline the payment process.
• Rent out a parking space or spare vehicle. If there's a high demand for parking spaces where you live, consider renting out a space in your garage or driveway. Or, you may want to rent out your car when it's not in use through a mobile app, like Turo or Getaround. Check with your insurance company before pursuing this opportunity to make sure you're appropriately covered.
• Create an investment fund. Invest in stocks, bonds, mutual funds, exchange-traded funds, cryptocurrencies or any combination of these to earn passively. Before you start investing, however, make sure you take care of your emergency savings, retirement fund and minimal debt. Returns aren't guaranteed with investment products, so you should only invest what you can afford to lose—a mistimed or unwise investment can easily wipe out your initial investment.

• Sell unwanted items online. Consider listing items you no longer want or need on an online marketplaces. Some charge a small listing fee; others let you post for free. The IRS doesn't consider these sales to be passive income. If you sell an item for more than you paid for it, you may owe capital gains tax. If you make a regular business of selling belongings for profit, you may need to file a Schedule C and pay regular income and self-employment taxes on your profits.

  Learn more: Do I Need to Report Online Marketplace Sales on My Taxes?

• Earn cash back from your credit card. You can get paid for making everyday purchases with a cash back rewards credit card. If you don't have a cash back rewards credit card, Experian's card comparison tool can help you find options you may qualify for. You could also opt for a travel rewards credit card that earns you points you can redeem for things like airfare and hotel stays.
• Become an affiliate marketer. If you have an online platform with a large following, take advantage of affiliate marketing opportunities. You'll have to spend a little time figuring out how to promote the product or service, but you probably won't have to invest to start earning money. But be mindful, though, that U.S. law requires you to disclose that you'll earn money from purchases made using your affiliate link.

How to Reduce Passive Income Taxes

If you're concerned about the bite taxes might take out of your passive income, consider these steps to minimize your tax liability.

Group Passive Activities

If you participate in more than one passive activity—for example, you own multiple rental properties—the IRS allows you to group them into a single "economic unit" for tax purposes. Grouping your activities can make it easier to show material participation or handle profit or loss from the disposition of a property.

Apply Losses and Credits

Special losses and credits apply to rental activity. As noted above, up to $25,000 in passive losses from real estate rentals can be used to offset non-passive income. Additionally, a number of passive activity credits, including low-income housing and rehabilitation credits, can help reduce your tax liability on passive rental income.

Reduce Taxes on Investments

If your passive income comes from investments, consider these tips for reducing your tax bill:

• Invest in tax-advantaged accounts. Using tax-advantaged accounts like IRAs, health savings accounts (HSAs) and 529 college savings plans may allow you to earn interest, dividends and capital gains tax-deferred or even tax-free.
• Choose long-term over short-term capital gains. Holding on to assets for more than a year before selling them allows you to pay lower long-term capital gains rates instead of higher short-term capital gains rates.
• Consider municipal bonds. Interest on municipal bonds may be exempt from federal, state or local taxes.

Tip: You may want to consult with a tax advisor before you pursue passive income opportunities to make sure you fully understand the potential tax liability—and so you can be prepared come tax time. A tax pro can also provide insights on recordkeeping and what documentation you may need when filing your return.

The Bottom Line

You can use passive income to supplement or replace your income from a job, but you typically can't use passive income to avoid paying taxes. Figuring out how your passive income is taxed (and how you'll need to document and report that income) is a critical step you should not overlook. If you need extra help, consider using tax preparation software or finding a tax advisor.